NOT-FOR-PROFIT INSIDER

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1 NOT-FOR-PROFIT INSIDER VOLUME 8 :: ISSUE 2 In This Issue: Summary of the Final Report of the IRS s Colleges and Universities Compliance Project Revenue Recognition: Services Received from Personnel of an Affiliate Your Story, Good or Bad What is Your Form 990 Telling the IRS? Findings Regarding the Underreporting of Unrelated Business Taxable Income Background: Summary of the Final Report of the IRS s Colleges and Universities Compliance Project In 2008, the IRS launched a tax compliance project focusing on colleges and universities in the United States. The project (named Colleges and Universities Compliance Project ) was initiated by the IRS with the mailing of fairly lengthy questionnaires to 400 randomly selected colleges and universities. The IRS then decided to conduct an in depth examination of 34 of the responding colleges and universities because their questionnaire responses and IRS Form 990 filings indicated potential noncompliance in the areas of unrelated business taxable income and compensation paid to their executives. An independent member of UHY International In addition to principally focusing on these two issues, the IRS also scrutinized the employment tax returns and retirement plan reporting at 11 and 8 colleges and universities, respectively. With more than 90% of these examinations completed, the IRS released in April 2013 its Final Report of the Colleges and Universities Compliance Project. The following is a discussion of some of the more interesting findings in the Final Report, and a wake-up call for all taxexempt entities in the way they handle these four tax compliance areas. Unrelated business income ( UBI ) is the income from a trade or business regularly conducted by a tax-exempt organization that is not substantially related to its tax exempt purpose. Unrelated business taxable income ( UBTI ) is the UBI that is taxable after deducting those expenses that are directly connected with the trade or business. Because UBTI is calculated by totaling the UBI from all trade or business activities and subtracting the total allowable deductible expenses of these activities, the losses from one activity can offset the profits from another activity. Results of Examinations: 1. Increases to UBTI for 90% of the returns examined totaling about $90 million; 2. Over 180 changes to the amounts of UBTI reported on IRS Form 990-T; and 3. Disallowance of more than $170 million in losses and NOLs which could amount to more than $60 million in assessed federal income taxes. Continued on Page 2... The next level of service

2 2 UHY LLP NOT-FOR-PROFIT INSIDER Continued from Page 1... Primary Reasons For Increases to UBTI: 1. The disallowance of deductions for expenses determined to have not been connected to the organization s unrelated business activities. The misreporting occurred because: a. Lack of profit motive - The IRS found that the organizations were claiming losses from activities that did not qualify as a trade or business. In this regard, nearly 70% of the examined organizations reported losses from activities for which expenses had for several years exceeded UBI. Since, in the view of the IRS, a pattern of recurring losses indicates a lack of profit motive, the IRS disallowed the reporting of losses for those activities, which, in turn, were no longer able to offset profits from other established trades or businesses of the organization. b. Improper Expense Allocation - The IRS found that, on nearly 60% of the IRS Forms 990-T that they examined, colleges and universities had misallocated expenses used to offset UBI for specific activities. Although organizations may allocate to the Form 990-T a portion of those expenses used to carry on both exempt and unrelated business activities, the allocation must be done on a reasonable basis and the expenses used to offset UBI must be directly connected to the UBI activities. In many cases, the IRS found that the claimed expenses were not connected to the unrelated business activity. 2. The NOLs reported on 1/3 of the examined returns were either improperly calculated or unsubstantiated, resulting in the disallowance of nearly $19 million in NOLs. 3. The IRS determined that nearly 40% of the returns examined had either (i) misclassified certain unrelated business activities as exempt activities (and thus not otherwise subject to taxation as UBTI), or (ii) simply not reported their unrelated business activities on IRS Form 990-T. Fewer than 20% of these activities generated a loss, resulting in the reclassification of nearly $4 million in UBTI. 4. In some cases, the organization failed to recognize all of its unrelated trades or businesses. For example, the following activities were oftentimes not correctly identified as unrelated business activities: Fitness, recreation centers, and sports camps; Advertising; Facility rentals; and Golf courses Findings Regarding the Payment of Executive Compensation Background: The executive compensation component of the examinations focused on compliance with Section 4958 ( Taxes on Excess Benefit Transactions ) of the Internal Revenue Code ( IRC ). Normally, the tax exempt organization has the burden of demonstrating that the compensation paid to its executives is reasonable. The organization can, however, shift the burden on this issue to the IRS if the organization can demonstrate that the following three conditions have been met which therefore entitle the organization to a rebuttable presumption of reasonableness (in this regard, see Treasury Regulation Section ): 1. The compensation amount has been approved in advance by a committee (the Committee ) composed of individuals who do not have a conflict of interest with respect to the determination of the compensation; 2. The Committee relies upon appropriate comparability data to set the compensation amount; and 3. The Committee contemporaneously documents the basis for its executive compensation determination. Results of Examinations: Although most of the private colleges and universities examined attempted to meet the rebuttable presumption standard, about 20% of them failed to do so because of problems with their comparability data. Primary Reasons For Failure to Make Comparable Comparisons: 1. The Committee relied upon data that was not from a comparable school because of differences in either: Geographical location: and/or Endowment size; and/or Gross revenues; and/or

3 UHY LLP NOT-FOR-PROFIT INSIDER 3 Total assets; and/or Number of students enrolled; and/or Selectivity in admissions policies (e.g., SAT ranges of admitees) 2. The compensation studies performed by the Committee neither documented the selection criteria for the schools included in the study nor explained why those schools were deemed comparable to the school relying upon the study. 3. Some of the compensation studies did not specify whether the compensation reported included only base salary or included other types of compensation (as required by IRC Section 4958). Findings Regarding Employment Tax Filings Results of Examinations: The IRS opened employment tax examinations at 11 of the 34 colleges and universities initially chosen to be examined. All of the employment tax examinations resulted in adjustments to the wages required to be reported to the IRS, amounting to increases in taxable wages of nearly $36 million, and generating approximately $7 million in employment taxes and tax penalties. Primary Reasons For Under-Payment of Federal Employment Taxes: Wages were adjusted for a number of reasons, including the following: 1. Failure to include in income the value of (i) the personal use of automobiles, (ii) housing, (iii) social club memberships, and (iv) travel; 2. Misclassification of employees as independent contractors; 3. Failure to withhold taxes for wages paid to non-resident aliens; and 4. Failure to include in income the value of graduate tuition waivers and reimbursements. Findings Regarding Retirement and Deferred Compensation Results of Examinations: The IRS opened retirement plan examinations at 8 of the 34 colleges and universities initially chosen to be examined and found compliance issues at about half of them. Examinations resulted in deferred compensation-related wage adjustments on IRS Forms 941 and 1040 of more than $ 1 million generating approximately $200,000 in federal taxes and tax penalties. Primary Reasons For Wage Adjustments Due to Retirement/ Deferred Compensation The wages of the organization s employees entitled to participate in the organization s plan of deferred compensation were increased primarily for the following reasons: 1. For those organizations that sponsored deferred compensation plans that did not meet the requirements of IRC Section 457(b), contributions under such plan were required to be recognized as current year income in the event the contributions were not conditioned on the future performance of substantial services sufficient to give rise to a substantial risk of forfeiture under IRC Section 457(f)(3)(B); 2. Loans from IRC Section 403(b) plans exceeded the IRC Section 72(p) limits resulting in the excess being treated as a deemed distribution from the plan required to be recognized by the participant in current year income; 3. Annual wage deferrals by one or more of the participants under the organization s IRC Section 403(b) plan exceeded the IRC Section 402(g) annual limits; and 4. Annual additions to one or more of the participants under the organization s IRC Section 403(b) plan exceeded the IRC Section 415(c) annual limits. Summary Although this report was focused on colleges and universities, the same issues apply to most tax exempt organizations. As we write this article, there is much discussion in the legislature about these findings so stay tuned for any potential changes the lawmakers attempt to make in an effect to prevent some of these things from happening. Article written by Heather Raschke, Principal and Don Hughes, Tax Manager Although this report was focused on colleges and universities, the same issues apply to most tax exempt organizations.

4 4 UHY LLP NOT-FOR-PROFIT INSIDER Revenue Recognition: Services Received from Personnel of an Affiliate In April 2013, the Financial Accounting Standards Board ( FASB ) issued an amendment to the guidance on notfor-profit revenue recognition policies, specifically relating to services received from personnel of an affiliate. Effective for fiscal years beginning after June 15, 2014, and interim and annual periods thereafter, a not-for-profit entity ( recipient ) is required to recognize all services received directly from personnel of an affiliate that directly benefit the recipient and for which the affiliate does not charge the recipient. These costs not being charged by the affiliate must be measured by the recipient at the cost recognized by the affiliate for the services provided. If the cost to be recognized will significantly overstate or understate the value of the services received, the recipient may elect to recognize the services at either the cost recognized by the affiliate for the personnel providing the services or the fair value of the services received. For financial statement presentation purposes, an increase in net assets associated with the services received and a decrease in net assets or the creation/enhancement of an asset shall be presented similar to how other such expenses or assets are presented, rather than being shown as a contra-expense or contra-asset. Disclosures of this amended policy in the financial statements can be presented in one of two ways: 1) prospectively for fiscal years beginning after June 15, 2014, and interim and annual periods thereafter and 2) using a modified retrospective approach in which all prior periods presented upon the date of adoption shall be adjusted, but no adjustment shall be made to the beginning balance of net assets of the earliest period presented. Early adoption of this amended policy is allowed by FASB. Article written by Lynn Rodriguez, Senior Staff Accountant

5 UHY LLP NOT-FOR-PROFIT INSIDER 5 Your Story, Good or Bad What is Your Form 990 Telling the IRS? I ll confess, I enjoy reading completed IRS Forms 990. They tell a story. Sometimes, the story is one to be admired and sometimes the story is not a good one. I urge my clients to use their 990s to tell the very best story they can while always, of course, being truthful. I also urge, coach, nag, cajole (and any other words that convey the same theme) them to closely review their 990 before filing to make sure it is error free. Now I have an even more persuasive argument to use: I can tell them about the nonprofits that fell under IRS scrutiny in 2012 because of information on their 990s that turned out to be incorrect. Let s start at the beginning. As all of you know, the IRS released a new version of the Form 990 in Back then, the IRS said the form was designed to promote transparency, improve compliance and decrease overall filing burden. Current IRS literature has dropped the part about decreasing filing burden, which is not surprising to anyone who has had to prepare one of these forms! So what is the IRS doing with all the additional information it s collecting? I ll tell you: The IRS is using the information in its compliance efforts. The IRS Office of Exempt Organiza tions (EO) of the Tax Exempt and Government Entities Division released its report on accomplishments and findings of its 2012 fiscal year and revealed its work plan for This report tells how the IRS is using Form 990 information to develop potential indicators of noncompliance for use in the examination process. Once developed, those potential indicators must be tested. Currently, the IRS is in the early stages of testing. I ll address some compliance projects worked on in FY 2012 that drew on data from the Form 990 and tested the indicators of potential noncompliance. Charitable Spending Initiative In FY 2010, the EO began studying the sources and uses of funds in the charitable sector and their relationship to the accomplishment of charitable purposes. The first phase looked at about 170 small organizations with high levels of fundraising expenses, organizations reporting unrelated trade or business activity with relatively low levels of program service expenditures, organizations with high ratios of officer compensation in comparison to program service expenditures, and organizations with low levels of program service expenditures in comparison to total revenue. In about one-third of the completed examinations, the reported high expense ratios turned out to be lower after examiners completed a full review of books and records. So almost 60 organizations had their staff burdened and stressed with an IRS examination unnecessarily simply because they did not complete the form correctly. More than 150 examinations have been completed. Four organizations did have their exempt status revoked because of insufficient charitable activity or inurement to an officer. Tax was assessed on the unrelated business income of three organizations. In 2013, the IRS will continue this project by identifying a group of medium to large organization for examination. It will be interesting to see if the larger orgs do a better job of accurately completing the 990. Form 990-T and Unrelated Business Income (UBI) In 2012, the IRS completed compliance checks of 400 organizations that had reported taxable UBI activities on their Forms 990 but had not filed the Form 990-T. Amazingly, examiners determined that almost 100 (nearly one-fourth) had incorrectly completed the 990. These orgs would not have been examined if the Forms 990 had been completed correctly. The IRS also determined that 140 of these organizations should have filed Forms 990-T resulting in $260,000 in tax Continued on Page 7...

6 6 UHY LLP NOT-FOR-PROFIT INSIDER THE IRS IS NOW FOCUSING ON ORGANIZATIONS REPORTING HIGH GROSS RECEIPTS WITH VERY LOW TOTAL COMPENSATION TO ALL OFFICERS, DIRECTORS, TRUSTEES AND KEY EMPLOYEES.

7 UHY LLP NOT-FOR-PROFIT INSIDER 7 Continued from Page 5... payments. So in total, 240 out of 400 organizations reported incorrect information on their Forms 990 about this one point. Two hundred and forty IRS examinations might have been avoided by the submission of a correct Form 990. The 2013 plan is to look at organizations reporting substantial gross UBI for three consecutive tax years but reporting no tax due for any of those years. The IRS will be checking to see if organizations are correctly allocating and deducting expenses from taxable streams of income. Political Activity The IRS has identified potential indicators which are being tested and applied. The IRS is using the indicators as a tool to flag organizations engaging in possible impermissible campaign intervention. At the time of the report over 300 such organizations had been identified. A committee of career civil servants will evaluate if examination is warranted. Compensation Transparency The IRS is now focusing on organizations reporting high gross receipts with very low total compensation to all officers, directors, trustees and key employees. The concern is whether organizations may be hiding compensation levels. A sample of 200 has been selected, comprised of stand-alone organizations and those reporting a relationship with one or more related organization. More information was gathered using the internet and internal sources. Examinations will begin in Governance Study The IRS did an analysis of the relationship between governance practices and compliance using checksheets on 1, (c)(3) orgs under examination. It was found that compliance is more likely with those orgs that 1) have a written mission statement, 2) use comparability data when making compensation decisions, 3) have controls in place to ensure the proper use of charitable assets, and 4) provide for Form 990 review by the entire board of directors before filing and do not have control of the organization concentrated in one individual or in a small, select group of individuals. In 2013, the IRS will examine a statistical sample of orgs using a checksheet to gather information on governance practices. The IRS will also be looking at how diversion of assets is influenced by governance. So, what is the message here? Pay attention to the story the IRS wants to see. Consider if your practices need modification. And, for goodness sake, if your real story is a good one, don t attract IRS attention by telling a wrong story in your Form 990. Article written by Jennine Anderson, Partner

8 NOT-FOR-PROFIT INDUSTRY INSIGHT With the increasing complexity of laws and regulations, it s important for associations, foundations, charities, hospitals, schools and other tax-exempt entities to seek out professionals with extensive experience in nonprofit compliance issues. We understand there are many challenges affecting the industry and provide the attention needed to help clients stay focused on their job at hand. UHY LLP s National Not-For-Profit Practice offers comprehensive audit and assurance, tax planning and compliance and business advisory services to meet the unique, complex needs of nonprofit organizations. These types of specialized services, which cut across the traditional service lines, demonstrate our philosophy of skilled professionals integrating industry expertise with technical services. OUR LOCATIONS CT New Haven GA Atlanta MD Columbia MI Farmington Hills MI Sterling Heights MO St. Louis NJ Oakland NY Albany NY New York NY Rye Brook TX Dallas TX Houston ADDITIONAL UHY ADVISORS LOCATIONS IL Chicago DC Washington Our firm provides the information in this newsletter as tax information and general business or economic information or analysis for educational purposes, and none of the information contained herein is intended to serve as a solicitation of any service or product. This information does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided as is, with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose. UHY LLP is a licensed independent CPA firm that performs attest services in an alternative practice structure with UHY Advisors, Inc. and its subsidiary entities. UHY Advisors, Inc. provides tax and business consulting services through wholly owned subsidiary entities that operate under the name of UHY Advisors. UHY Advisors, Inc. and its subsidiary entities are not licensed CPA firms. UHY LLP and UHY Advisors, Inc. are U.S. members of Urbach Hacker Young International Limited, a UK company, and form part of the international UHY network of legally independent accounting and consulting firms. UHY is the brand name for the UHY international network. Any services described herein are provided by UHY LLP and/or UHY Advisors (as the case may be) and not by UHY or any other member firm of UHY. Neither UHY nor any member of UHY has any liability for services provided by other members UHY LLP. All rights reserved. [0613]